Now, we’ll talk about how much of each investment we’ll want in our portfolio, otherwise known as asset allocation. We’ll want a diverse blend of investments, in a ratio that is appropriate to our own situation (age, risk tolerance, retirement goals, etc.).

By holding a variety of funds/stocks/bonds/whatever, we will spread our risk so if any one investment does poorly, it won’t wreck our situation. And, when another fund does well, we’ll get some of those gains. Having a proper asset allocation is crucial!

Let’s pretend we’re going out to a restaurant for dinner. The waiter brings bread for you to nibble on while you look over the menu. You decide on an appetizer trio so you can have a few bites of several choices, rather than just one. You choose the house salad and it arrives with a blend of greens, veggies, croutons and dressing.

Your entree is a choice cut of meat with a few sides, and you wash it down with iced tea.

This particular restaurant is known for their amazing desserts, and you can’t make up your mind. You again choose a sampler — three shot-glass sized bites of sweets, along with a cup of coffee.

Think about all that food. There was a large variety and you didn’t load up on any one thing. Compare that meal to what it would have been like if you ordered four fried chickens and a Coke*. Not a balanced meal. You’d miss veggies and desert!

That dinner analogy sort of demonstrates what I’m talking about with asset allocation. Some funds can be considered your entree — you’ll want a larger portion to come from this. Others are your dessert. A little goes a long way, and too much dessert could leave you with a belly ache.

What percentage of which funds?

Last week, we learned about large cap and small cap funds. We don’t want 100% small caps, because that could be tremendously risky. However, since they are like dessert, we do want some. The asset allocation for a 26-year-old is not going to be the same as a 56-year-old.

This asset allocation calculator from CNN Money asks a few questions about your risk tolerance and how soon you’ll need your money, and it creates a pie chart suggesting how much you’ll need in each type. My results say 50% large cap, 20% foreign, 20% small cap, 10% bonds.

Use these calculators as a starting point, and further adjust this mix according to your own situation. Your age now, projected age at retirement, projected life span, risk tolerance, and how much you already have invested are all factors.

Say you determine you want a blend like that first example. You’d choose a low-fee large cap fund and have 50% of your regular contributions going to that fund. Next, you’d choose a foreign fund and have 20% of your contributions going there, and so on. If you’re contributing $300 each paycheck, then $150 would go to your large cap fund, $60 would go to foreign and small cap each, and $30 would go to bonds.

Once you set it up in the way you won’t, you won’t have to keep messing with it.

Rebalancing

Over time, we’ll need to rebalance our investments. Some experts suggest every 12-18 months, we’ll need to sit down and look at our entire portfolio and rebalance it.

You know that saying, “Buy low, sell high”? Well, that’s where this comes into play. For the sake of simplicity, say you want your portfolio to have 60% in stocks and 40% in bonds. In a year’s time, your stock holdings grow and your bonds hold steadily.

When looking at the total dollar amount, your stock holdings now represent 70% of your portfolio, and bonds represent 30%. To keep your asset mix in the 60/40 blend, you can do it a few ways:

Sell some of your stock funds and use the proceeds to buy more bonds, immediately bringing it back to 60/40 mix

Don’t sell a thing. Instead, stop adding more money to your stock fund for awhile, and divert all new contributions to your bonds until you’re back at the ratio you want. If your ratio isn’t off by much, you could try this approach, assuming it won’t take you long to get back to your desired ratio. But if it’s way skewed, it might take too long.

An example with target date funds

If you don’t care to choose the asset allocation yourself or rebalance it every year, you can select a target date fund. Remember, each company’s target date allocation is a little different from another company’s with the same year, so look at them closely to determine what fits your needs — your risk tolerance, your retirement goals. You could choose a fund with a different year, say bumping it ahead by 10 years if you want to be more aggressive, or choosing an earlier date for a more conservative fund.

You can also look at how a target date fund allocates its holdings and use it as a guide for your own. For example, the Vanguard Target Retirement 2050 (VFIFX) fund contains:

This series is almost through! Next week, I’ll wrap it up. I’d like to answer any questions you still have — things I didn’t explain clearly, or topics I missed. What questions do you still have about retirement planning?

Asset allocation is so important, and it’s key to overall rates of return. I try to do it every year, though I don’t schedule it or anything like that. Personally, I like doing it my own way versus target date funds.

Good post, you’ve got me thinking of one of my own here, based on someone I know…